10 Worrying Signs that Your Stock May be a Value Trap

Value Investing is all about identifying stocks with unidentified or underappreciated potential and waiting for that value to be realised over time. However, it's always worth remembering that some stocks are cheap for a reason. Of course, we all hope that the market will come to recognise what a bargain our latest investment was. But, every now and then, a price fall may lure you into every value-investor's nightmare - a false bargain, better known as a value trap.

What is a Value Trap?

A value trap is a company that appears cheap because of a large price fall, but which is actually still expensive relative to intrinsic value. In effect, it is masquerading as a value stock. It looks like a bargain price because it has come down so much but, despite the allure of a low price, a value trap's price is low for a good reason - unlike a true value stock, these companies are experiencing a fundamental change in their business prospects and could basically dying companies. As Warren Buffet said, "price is what you pay, value what you getquot;.

Earnings-driven value trap - This is where the mirage of a low price/earnings valuation vanishes as EPS evaporates over time - every time you think it looks quot;cheapquot; again, earnings fall further. This process is usually persistent and can last for years. More often than not, the misguided investment thesis is some variation of quot;They used to earn X, so if they could just get back to something near X, the stock would work wellquot;.

Asset-based value trap - Also known as quot;cigar-buttsquot;, these types of stocks look exceptionally cheap in terms of asset valuation (e.g. the price/book ratio relative to current profitability). In some cases, the trap is simply that the reversion to the mean of unsustainably high profitability. However, Fidler suggest that the real danger comes from companies with opaque or ill-defined risks where the flawed investment thesis is quot;I know the risk is there, but I think it is already in the price or over-discountedquot;.

How to avoid Value Traps...

Of course, it's easy to say with hindsight that a failed investment was a value-trap but are there any ways to flag this in advance? Fundamentally, the key to avoiding value traps is doing your homework and exercising caution when approaching enticing investment prospects. It's crucial to be as precise as possible about intrinsic value through fundamental bottom-up company analysis. The other issue is that it's important to have an adequate margin of safety since this is the value investor's buffer against errors in the intrinsic value calculation. However, beyond that, there are some common fact-patterns that it's worth watching out for....

Top 10 Signs that Your Stock May be a Value Trap

So here's a list of 10 tell-tale questions to ask to help figure out whether your beloved investment may in fact be a steel trap - this list is inspired by the excellent presentation given by James Chanos of Kynikos Associates at last year's Value Investing Congress.

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In no particular order, these tell-tale signs are:

1. Is the sector in long-term secular decline?

A company may simply be serving a market that no longer exists in the way it used to. No matter how good the company, it will need a fair wind behind it eventually and and if the sector itself is dying, it's likely to be a huge battle to realise value. From a demand perspective, it's important to distinguish between cyclical and secular declines. In the former case, short-term demand will rebound with an improved economy. In the latter case, demand is in long-term decline (e.g. due to societal and demographic changes), which means that the remaining players are left to fight for a share of an ever-decreasing pie. This is the trap that Warren Buffett faced at Berkshire Hathaway, which was a failing textiles business that he was unable to turn around before he switched the focus completely into insurance.

2. Is the risk of technological obsolescence high?

Technological progress can radically reshape an industry and its product lines - this can have a major impact on the life cycle and profitability of a firm (e.g. the impact of the Internet on both newspapers and retailers). Chanos argues that this has killed value investors more than anything in the past 10-20 years. One might assume that a stock is cheap enough to compensate for decreasing cash flow but, sometimes, cash flows hits a tipping point and drops off faster than you expect. A example given was Blockbuster which apparently saw free-cash-flow go from $2bn to $500m in just 18 months! Having said all that, the cycle of creative destruction can be unpredictable - the US steel industry was given up for dead in the 1980s but was reinvigorated by the invention of lightweight mini-mills.

3. Is the company's business model fundamentally flawed?

Sometimes, a company may simply be serving a market that no longer exists, or at a price-point that is no longer relevant, given competition and/or new substitutes for the product. An example here might be K-Mart which looked extremely cheap in the late 1990s vs. say Walmart but the lack of a competitive business model meant that the company's earnings continued to plummet. Because of leverage (see next point!), Kmart filed for bankruptcy in 2002. Alternatively, maybe it was just a dumb idea in the first place, or a good idea badly-executed. While Tesco have shown that online grocery deliveries can work, WebVan burnt through $375 million in the dotcom era through investors overlooking extremely thin margins, unreliable delivery times, and a lack of customer demand.

4. Is there excessive debt on the books?

More often than not, financial leverage magnifies the pain of a value trap. Limited or no financial leverage gives firms access to the the most precious commodity of all - time! A company with no debt is unlikely to go under, barring a major catastrophe (e.g. a massive legal settlement against it). On the other hand, excessive leverage can destroy even a great company. For a good margin of safety, the debt to equity ratio should be as low as possible (and certainly below 1), and interest cover should be comfortable. Conservative financing is one of the key criterion discussed as part of the Buffetology screen.

5. Is the accounting flawed or overly aggressive?

It's best to stay away from companies where aggressive or dubious accounting is employed. Chanos argues that you should be "triply careful" whenever management uses some metric that they define, rather than conventional metrics (Cable TV, Eastman Kodak, Blockbuster, and Tyco have been examples of this in the past). If a company is only cheap on management's metrics, such as EBITDA while ignoring restructuring charges, this means very little.

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Likewise, it's probably best to avoid with a wide berth stocks that have dropped in price due to to corporate fraud. Some investors bought Parmalat's bonds in the summer of 2003 on the basis that they were cheap for a company with a strong cash position and balance sheet only to find that the Italian dairy group collapsed later that year with €14bn ($18.5bn) of debts. Published financial statements always have to be taken with a grain of salt and, wherever fraud is involved, the figures used to determine value are probably meaningless. Montier's C-Score and the Beneish M-Score may both help to flag issues here.

6. Are there excessive earnings-estimate revisions?

Analysts are quite lenient and usually revise their estimates downward before earning releases to allow companies to beat their estimates. Occasional missed earning estimates can provide an opportunity to buy on the dip, but a pattern of missing earning estimates may mean that management are struggling to forecast properly, with a knock-on effect for the analysts, and/or that management doesn't understand or are not willing to fix problems.

7. Is competition escalating?

Be careful of companies facing increasingly stiff competition. Is there a tendency for the industry to compete on price to squeeze margins? If there are limited barriers to entry and a company is unable to differentiate itself, then it's possible that the market structure has simply moved against it - it may never recover the glory years of the past. One way to test this is to compare the historic profit margin trend ove the last 10 years. If the profit margins are decreasing, this may suggests the company is unable to pass increasing costs onto its customers due to increased price competition.

8. Is the product a consumer fad?

Another sign of a possible value trap is a product that is subject to consumer fashion or whims. Evolving consumer tastes and demand may mean that the market for the product is just a short-term phenomenon. An example of this is arguably Hot Tuna - as Growth Company Investor has noted:

quot;the surfwear fashion concept has for some years become increasingly out of fashion since the late nineties... with Hot Tuna reporting losses every year since 2006quot;.

9. Are there any worrying corporate governance noises?

It's worth checking for any history or noise that suggests minority shareholders might be getting a raw deal. In general, while there are notable exceptions (e.g. Berkshire Hathaway), investors should probably be wary of companies with a second class of stock with super-voting rights. The risk here is that that the company will focus on keeping insiders happy at the expense of common shareholders. A related flag is a very limited float or tightly held company - while insider ownership can mean that incentives are aligned, it may also act as a deterrent for institutional shareholder participation (since they will find it difficult to trade in large quantities of stock).

10. Has the business grown by acquisition?

Chanos argues that growth by acquisition is a major sign of a value trap. In particular, rollups of low growth, low P/E businesses with expensive high P/E stock should be seen as a red flag. Be careful when you see big write-downs because, while management is claiming to be conservative, they are likely to be banking some earnings. Chanos gave the example of Tyco - in its last year of business, it apparently bought $20 billion worth of businesses, and put $21 billion of goodwill on its books!

And you still need a catalyst...

Even if the investment doesn't suffer from any of these risks, the investment may still end up being a dreary and difficult one, if there's no near-term catalyst for the crystallisation of value. Via Expecting Value, we came across a useful catalyst definition by value blogger, Wexboy as:

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quot;any kind of transaction/fact/event/etc., actual or potential, that offers the opportunity for a full/partial realization of value in a stock, within a (reasonably) accelerated timescalequot;.

Many seasoned investors and sell-side analysts wait until a catalyst gets ready to hit the market and buy or recommend the stock then. In the absence of any obvious catalyst, time will probably do the trick eventually but, in the long run, we are all dead. And, as Wexboy notes, an extended wait for value to be crystallised can have a dramatic effect on your returns:

quot;You've found a neglected jewel, and based on your value investing acumen (and a decent Margin of Safety) you confidently expect that will ultimately capture an upside of, say, 75%. But when will that happen? In 3 yrs, 5 yrs, 7 yrs..?! Those periods equate to IRRsof 20.5%, 11.8% and 8.3%pa respectively. Now assume a catalyst exists that's successful in prompting a realization of that full 75% upside within 1 year. That is, of course, a 75% IRR! quot;

Some examples of possible catalysts include: i) fresh management with new direction, ii) a change in strategy of existing management (e.g. new product strategy, business reorganisation or cost reductions), iii) a disposal or purchase of a meaningful asset, iv) a recapitalisation of the business, v) a takeover bid, or vi) activist shareholders who may put pressure on management to act.

The Chairman: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about - by advertising or what happens?

Mr. Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it one way or another.

However, while patience is a virtue, patience should not be confused with naive optimism. As Warren Buffett has said, quot;i n a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchenquot;. One way to ensure that you're not left waiting forever for value to be crystallised is to review the above criteria and avoid value traps at all cost. And focus on identifying catalysts to unlock value quickly, wherever possible.